The Libor scandal rolls on – feeding a common perception of widespread bank misbehaviour. This column argues that understanding the crisis strengthens the sense of a conspiracy, but weakens the sense of criminality. The Libor system could not function in periods of extreme stress where the interbank market disappeared and reporting higher borrowing costs led to even higher borrowing costs. As Mervyn King said, Libor was the rate at which the banks didn’t lend to each other. One possible reform would replace Libor with some commonality of lending rates between major central banks and prime banks.

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The public is baying for blood. The Libor scandal has become a lightning rod for the public’s anger against bankers. Not unfairly, bankers are seen as having:

Lobbied for and received light-tax and inadequate regulatory treatment to support their unsustainable activities;

Gobbled up a disproportionate amount of the illusion of wealth created in the early boom years, and;

When the Towers of Babel came crashing down, enormous bailouts had to be financed by ordinary taxpayers and pensioners.

To many, the Libor scandal offers the 'smoking gun' evidence of collusion between bankers and regulators against the wider public. The resignation of the Barclays CEO Bob Diamond, has only increased the public’s appetite for more. Who knew what, when? The public demands to know.

But pause a little to examine the notes on this scandal. When you do, the sense of a conspiracy becomes clearer, but the crime becomes less so. It is not illegitimate to worry about what would have happened were the alleged crime not committed - which is not to let bankers and regulators off the hook.

How Libor works

The Libor (London Interbank Offered Rate) is calculated and published by Thomson Reuters on behalf of the British Bankers' Association (BBA). Since 1986, each day at 11am London time, the cash management departments of, on average, 16 of the world’s largest international banks, have sent in responses to a questionnaire on the level of interest rates they can borrow from other large international banks, or that they are prepared to lend to them at, across ten different currencies and 15 different maturities.

A typical submission would include the rate a bank can borrow US dollars, Japanese yen or British pounds for one day, three months or 12 months. The reported rate is a 'trimmed average' of these submissions: the highest 25% and lowest 25% of the rates submitted are removed and the arithmetic mean of the remaining submissions is calculated and posted around 11.45am. The Bank of England played a consultative role in the development of these arrangements.

Those looking for 'smoking gun' evidence of conspiracy and crookedness pounce on the fact that Libor is a survey and not an average of actual borrowing and lending rates. There were good reasons for this practice of 26 years. Although money market rates are substantial in aggregate, at a specific point in time, for a specific currency at a specific maturity, they are not always liquid and so rates can vary significantly from one hour to the next. Longer-term averages could have been used, but it was felt that these would not reflect underlying conditions that day, which is the purpose of Libor – and, it was felt that banks are incentivised to submit realistic estimates of the underlying conditions because they are both substantial lenders (who would want higher Libor) and borrowers (who would want lower Libor) and they could not easily predict which they would be more of on a given day.

How much collusion would be necessary to manipulate rates?

This method of estimation – where the extremes are trimmed – makes it impossible for one bank, which has a large net lender or borrower position, to manipulate the Libor rate on its own.

Any manipulation would need collusion by a minimum of a quarter plus one of the banks being surveyed.

These banks would have to have similar net positions – so that their interests were aligned in favour of the collusion – and the offsetting position (these banks are lending and borrowing from each other and so someone’s lending is another’s borrowing) would have to be so widely distributed so as not to trigger an offsetting collusion.

In other words, manipulation of these rates for private profit would be difficult to arise or sustain.

Libor scandal: A story in two parts

The Libor scandal has two phases.

Between June 2007 and June 2008 – i.e. in the early days of the crisis, when banks still lent to each other – news that any bank had submitted rates higher than average, lit speculation that the bank was in trouble.

This speculation became self-fulfilling as banks stopped lending to any bank under a cloud of rumour and speculation. One of the suggestions for reform of Libor sent by the then president of the New York Fed, Tim Geithner, to the Bank of England Governor, Sir Mervyn King, in June 2008 was to try and reduce the transparency over which bank had made what submission, but the reality is that at times of crisis little is secret and attempts to obfuscate breed harmful speculation.

The Bank of England has strenuously denied that at this time it suggested in any way for Barclays or other banks to submit lower rates in its Libor submission, but for whatever reason, this was the interpretation that Barclays took away. The problem for the Bank of England is that although national and international officialdom respectively accepts the Bank’s denials, this interpretation makes a lot of sense.

In the heat of the crisis, it would be entirely reasonable for the Bank of England to consider that avoiding a speculative attack against one of Britain’s largest banks. Such an attack would have seriously threatened the viability of the UK’s financial system. As such safeguarding the financial system’s stability was a far greater priority than safeguarding the future integrity of Libor.

During financial crises, central bankers make these kinds of unenviable choices all day long – mortgaging the future in order to ensure there is one.
If this was their choice, few in Britain would question it, but it would clearly undermine the City of London’s position as banker to the world. Libor is the benchmark rate for roughly $500 trillion of debt around the world. No surprise then that the investigation into whether Libor submissions were being manipulated downward was led by agencies in the US; agencies in the UK played noisy catch up.

The second part of the Libor scandal comes after the collapse of Lehman Brothers on September 15th, 2008.

Although Lehman’s was one of the smaller investment banks, its counter-party exposures and gross liabilities proved extensive. At that point banks largely stopped lending to each other as they were uncertain as to the liabilities of other banks.

The European Central Bank, the Bank of England and the Federal Reserve stepped in to the breach with generous lending terms to the banks, starting a process where they effectively disintermediated the inter-bank market. Why lend or borrow to a bank with uncertain credit quality when you can do so on generous terms with the central bank. Banks borrowed from the central bank and often safely parked surplus cash there as well.

Given that the interbank market no longer functioned, should the banks on the Libor panel have submitted no rates at all, causing havoc to the $500 trillion of loans and other instruments priced-off Libor?

Or should they submit rates that reflect their average non-customer borrowing and lending costs which is largely influenced by the lending and borrowing terms of the central bank?

They did the latter and while this was unsettling, it was not secret.

Mervyn King was fond of joking with journalists about Libor being the rate of interest at which the banks did not lend to each other. But the more the banking system effectively borrowed from the central bank at near-zero rates and lent, not to other banks but to customers, at Libor plus, the more the interest amongst the banks became aligned to pushing up posted Libor rates, collectively.

In closing…

Whether these higher Libor rates reflect tighter credit conditions than reality, or were merely a better picture of a broken reality is debatable.

What is clear is that the Libor compilation was designed for 'well-functioning' markets that exist for the vast majority of time, and not for periods of extreme stress where the inter-bank market disappears or reporting higher borrowing costs leads to even higher borrowing costs.

These are the fundamental problems with Libor that need to be solved and even if they are solved, Libor has suffered substantial damage to its credibility. When the chips are down, in a crisis, London has been found to be a British city not an international one.

Changing from a survey to actual rates has some merit, but would not solve these problems and could have made them far worse.

We have learned that in a crisis the one continuous rate is the rate at which the central bank will lend to banks and that rate is a true, realisable rate.

Maybe we should simply strive for some commonality of fixings of the rate the major central banks will lend to prime banks across different maturities and facilitate the switching of contracts from Libor plus, to central bank fixing plus and let Libor wither away.

The degree to which the City of London’s influence will follow is the next major question.